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On the Microeconomic Foundations of Linear Demand for Differentiated On the microeconomic foundations of linear demand for differentiated products Rabah Amiry, Philip Ericksonz, and Jim Jinx July 9, 2015 Abstract This paper provides a thorough exploration of the microeconomic foundations for the multi- variate linear demand function for differentiated products that is widely used in industrial or- ganization. A key finding is that strict concavity of the quadratic utility function is critical for the demand system to be well defined. Otherwise, the true demand function may be quite com- plex: Multi-valued, non-linear and income-dependent. The solution of the first order conditions for the consumer problem, which we call a local demand function, may have quite pathological properties. We uncover failures of duality relationships between substitute products and com- plementary products, as well as the incompatibility between high levels of complementarity and concavity. The two-good case emerges as a special case with strong but non-robust properties. A key implication is that all conclusions derived via the use of linear demand that does not satisfy the law of Demand ought to be regarded with some suspiscion. JEL codes: D43, L13, C72. Key words and phrases: linear demand, substitutes, complements, representative consumer, Law of Demand. We gratefully acknowledge helpful conversations with Wayne Barrett and Heracles Polemarchakis. yDepartment of Economics, University of Iowa (e-mail: [email protected]). zDepartment of Economics, University of Iowa (e-mail: [email protected]). xDepartment of Economics, University of St Andrews, U.K. 1 1 Introduction The emergence of the modern theory of industrial organization owes much to the development of game theory. Due to its priviledged position as the area where novel game theoretic advances found their initial application in an applied setting, industrial organization then served as a further launching ground for these advances to spread to other areas of economics. Yet to explain the success of industrial organization in reaching public policy makers, antitrust practitioners, and undergraduate students, one must mention the role played by the fact that virtually all of the major advances in the theory have relied on an accessible illustration of the underlying analysis using the convenient framework of linear demand. While this framework goes back all the way to Bowley (1924), it received its first well-known treatment in two visionary books that preceded the revival of modern industrial organization, and yet were quite precise in predicting the intimate link to modern game theory: Shubik (1959) and Shubik and Levitan (1980). Then early on in the revival period, Dixit (1979), Deneckere (1983) and Singh and Vives (1984) were among the first users of the linear demand setting. Subsequently, this framework has become so widely invoked that virtually no author nowadays cites any of these early works when adopting this convenient setting. Yet, despite this ubiquitous and long-standing reliance on linear demand, the present paper will argue that some important foundational and robustness aspects of this special demand function remain less than fully understood.1 Often limiting consideration to the two-good case, the early literature on linear demand offered a number of clear-cut conclusions both on the structure of linear demand systems as well as on its potential to deliver unambiguous conclusions for some fundamental questions in oligopoly theory. Among the former, one can mention the elegant duality features uncovered in the influential paper by Singh and Vives (1984), namely (i) the dual linear structure of inverse and direct demands (along with the clever use of roman and greek parameters), (ii) the duality between substitute and complementary products and the invariance of the associated cross-slope parameter range of length one for each, and (iii) the resulting dual structure of Cournot 1 One is tempted to attribute this oversight to the fact that industrial economists’strong interest in linear demand is not shared by general microeconomists (engaged either in theoretical or in empirical work), as evidenced by the fact that quadratic utility hardly ever shows up in basic consumer theory or in general equilibrium theory. 2 and Bertrand competition. In the way of important conclusions, Singh and Vives (1984) showed that, under linear demand and symmetric firms, competition is always thougher under Bertrand then under Cournot. In addition, were the mode of competition to be endogenized in a natural way, both firms would always prefer to compete in a Cournot rather than in a Bertrand setting. (Singh and Vives, 1984 inspired a rich literature still active today). Subsequently, Hackner (2000) showed that with three or more firms and unequal demand intercepts, the latter conclusion is not universally valid in that there are parameter ranges for which competition is tougher under a Cournot setting, and that consequently some firms might well prefer a Bertrand world. Hsu and Wang (2005) show that consumer surplus and social welfare are nevertheless higher under Bertrand competition for any number of firms. With this as its starting point, the present paper provides a thorough investigation of the micro- economic foundations of linear demand. Following the aforementioned studies, linear demand is derived in the most common manner as the solution to a representative consumer maximizing a utility function that is quadratic in the n consumption goods and quasi-linear in the numeraire. When this utility function is strictly concave in the quantitites consumed, the first order conditions for the consumer problem do give rise to linear demand, as is well known. Our first main result is to establish that this is the only way to obtain such a micro-founded linear demand. In other words, we address the novel question of integrability of linear demand, subject to the quasi-linearity restriction on candidate utility functions and find that linear demand can be micro-founded in the sense of a representative consumer if and only if satisfies the strict Law of Demand in the sense of decreasing operators (see Hildenbrand, 1994), i.e., if and only if the associated substitution/complementarity matrix is positive definite. As a necessary first step, we derive some general conclusions about the consumer problem with quasi-linear preferences that do not necessarily satisfy the convexity axiom. In so doing, we explicitly invoke some powerful results from the theory of monotone operators and convex analysis (see e.g., Vainberg, 1973 and Hildenbrand, 1994), as well as a mix of basic and specialized results from linear algebra. We also observe that strict concavity of the utility function imposes significant restrictions on the range of complementarity of the n products. For the symmetric substitution matrix of Hackner 1 (2000), we show that the valid parameter range for the complementarity cross-slope is ( n 1 , 0), 3 which coincides with the standard range of ( 1, 0) if and only if there are exactly two goods (n = 2). In contrast, the valid range for the cross parameter capturing substitute products is indeed (0, 1), independently of the number of products, which is in line with previous belief. We also explore the relationship between the standard notions of gross substitutes/complements and the alternative definition of these relationships via the utility function. Here again, the conclusions diverge for substitutes and for complements as soon as one has three or more products. All together then, the neat duality between substitute and complementary products breaks down in multiple ways for the case of three or more products. Another point of interest is that, in the case of complements, as one approaches from above the 1 critical value of n 1 , the usual necessary assumption of enough consumer wealth for an interior solution becomes strained as the amount of wealth needed is shown to converge to infinity! This further reinforces, in a sense that is hard to foresee, the finding that linear demand is not robust to the presence of high levels of inter-product complementarity! Since many studies have used linear demand in applied work without concern for microeco- nomic foundations,2 it is natural to explore the nature of linear demand when the strict concavity conditions on utility do not hold. In other words, we investigate the properties of the solution to the first order conditions of the consumer problem. For simplicity we do so for the n-good fully symmetric case (i.e., all off-diagonal terms of the substitution matrix are equal). Due to the lack of strict concavity, this will be only a local extremum (with no global optimality properties), which we term a local demand function. We find that, depending on which violation of strict concavity one allows, several rather unexpected exotic phenomena might arise. Demand functions might then fail the Law of Demand, even though each individual demand might remain downward-sloping in own price. For another parameter violation, individual demands might even be upward-sloping in own price (i.e., Giffen goods with a linear demand). In particular, we explicitly solve for the global solution of the utility maximization problem with a symmetric quadratic utility function that barely fails strict concavity, and show that the resulting demand can be multi-valued, highly non-linear and overall quite complex even for the two-good case. (Though similar effects will apply, higher 2 A classical example appears in Okuguchi’s(1987) early work on the comparison between Cournot and Bertrand equilibria, which is discussed in some detail in the present paper. 4 values of n appear to be intractable as far as a closed-form solutions are concerned). As a final point, we investigate one special case of linear demand with a local interaction struc- ture. This is characterized by the fact that the representative consumer is postulated as viewing products as imperfect substitutes if they are direct neighbors in a horizontal attribute space and as unrelated otherwise.
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